How do the rich build their wealth?
First, rich people know that in order to accumulate wealth, they must avoid paying high taxes. Many well-off folks are business owners who generally receive tax breaks and avoid making excessive payments to Uncle Sam. Rich people also spend differently than middle class and poorer Americans. The rich pay themselves first and their bills second, while most people pay their bills first and try to save anything that's leftover.
But, the rich aren't simply avoiding high taxes and paying themselves first; they also use their money to create more money. By stockpiling their cash in equities, bonds and other income-producing assets, rich people allow their money to work for them by generating capital gains and dividends, which are taxed less than ordinary income.
All of this sounds great for the top 10%, but how can low-income and middle class Americans use these same techniques to build wealth?
Economic empowerment starts with personal finance and taking specific steps to eliminate debt, cut expenses, and reduce your tax burden. If you're serious about building wealth, here are five (5) of the most critical steps you can take to get started:
Don't just save the difference; invest it.
If you bring home $1000 a month, you should be spending less than $1000 per month and investing the remainder. For example, after paying bills, utilities, food, gas, etc., the remainder of your income should be placed into an investment account such as a Roth IRA. The remainder should be approximately 10% to 15% of your total take-home pay.
Jack Bogle, founder of The Vanguard Group -- the world's largest mutual fund company -- says you shouldn’t try to beat the market and invest in low-cost index funds. "If you hold the stock market (index) you will grow with America," says Bogle, who is known for his "common sense" investing. In his book The Little Book of Common Sense Investing, Bogle explains: "Successful investing is all about common sense. Simple arithmetic suggests, and history confirms, that the winning strategy is to won all of the nations’ publicly held business at very low cost. By doing so you are guaranteed to capture almost the entire return that they generate in the form of dividends and earnings growth," says Bogle.
Remember that all investing is a risk; the markets will go up and down over time, but if you hold your investments for the long haul, your investments will grow. Don’t overthink it. Just buy the index and the miracle of compounding interest will do the rest.
Stashing your hard-earned cash in a savings account is okay, but it won't generate much growth. Over time, inflation will erode the value of your dollars, so simply putting money into a savings account won't work because it doesn't take advantage of compounding interest, which is crucial for long-term growth.
If you have credit cards and maintain a balance from month to month, you're losing money. Extremely high interest rates -- which typically range anywhere from 7.9% to as high as 29.99% -- are designed to keep you in debt. In order to build wealth, you must get rid of high interest credit cards. If you have multiple credit cards with balances, strive to pay down the highest interest card first, but continue to pay at least the minimum on each card. You should also discontinue usage of the highest interest cards and pay more than the minimum on it.
Even if it means working a second job temporarily, you may have to bring in more income to help pay down your credit card debt. If you only pay the minimum and your interest rate is over 20%, it is likely that your debt won't be paid off for 10 - 30 years.
You won't get rich working for someone else. However, if your employer offers a 401K or other tax-advantaged account, you should utilize this savings vehicle to grow your assets. A 401(k) invests in the stock market, so be sure to choose low-cost index funds such as those offered by Vanguard, T. Rowe Price, and Fidelity. Low-cost means low expense ratios, no loads, and no upfront fees that will ultimately diminish your overall investment.
If your employer offers a match (usually between 1%-10%) they are basically giving you free money. According to the U.S. Census Bureau, only 35% of Americans are utilizing their employer's 401(k). Of course, not every company offers a 401(k); some employers provide 403(b) and 457(b) plans, which are tax-deferred retirement savings programs that do not typically come with a matching contribution.
As of 2018, workers under age 50 can contribute up to $18,500 a year to a 401(k), while those 50 and older can contribute up to $24,500.
Tax laws can be complicated, but there are a few things you can do to ensure you're paying the lowest taxes possible. First, check your W-4 form to see if you're giving the government too much money. If you're receiving huge refunds after filing your taxes, your W-4 form is probably filled out incorrectly. The W-4 is completed when you're first hired so that your employer can withhold the correct federal income tax from your paycheck. And, according to the Internal Revenue Service (IRS), you should review your W-4 form each year and complete a new form when your personal or financial situation changes.
The IRS encourages everyone to use its Witholding Calculator to perform a quick "paycheck checkup," which is even more important for the coming years because of recent changes to the tax laws included in included in the Tax Cuts and Jobs Act. The IRS has concluded that the average refund is about $53 a week ($2800 a year). Over 80% of taxpayers receive refunds, which means they are giving the government an extra $53 a week in taxes.
You should also take inventory of how much you're spending each month on personal luxuries, transaction fees, and miscellaneous expenses. Write down the amounts you spend each month on items not typically included in monthly expenses (e.g. high-priced lattes, clothes, jewelry, vending machines, over-the-limit and late fees, monthly magazine or shopping club subscriptions, and account maintenance fees). On average, Americans spend a combined $130 a month on these items, and most can be eliminated either temporarily or permanently.
In order to really increase your wealth, you must own a home-based business. A home-based business will allow you to take advantage of tax breaks that lower your taxable income. When you operate a home-based business -- whether it's freelance writing, jewelry-making/crafts, hairstyling, or business consulting -- you can take advantage of the government's desire to see small businesses succeed and grow.
The tax benefits of operating a home office can be tremendous. Depending on your setup, you can deduct a portion of your home's expenses (i.e. mortgage interest, utilities, property taxes, maintenance) from your business income. You can also deduct expenses for things use you already use for personal reasons, but also use for your business such as your mobile phone, gas and mileage, meals/entertainment, and a portion of the costs for computers/laptops and other equipment used for business purposes.
Home office tax deduction rules can be hard to grasp. Consult with a tax advisor if you need help exploring your options.
For more information on home-based business tax advantages, review Intuit's Turbo Tax Small Business Tax Tips & Videos.
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